What are the costs of currency hedging for Norwegian high yield funds, and what is the optimal hedge strategy to limit these costs?

Abstract

As Norwegian high yield funds invest in foreign denominated assets, a risk associated with the exchange rate fluctuations occur and adds to the underlying risk of the asset. A common approach to this added risk is to utilize currency hedging activities to cope with the fluctuations and limit (or eliminate) this risk. However, such activities come with costs associated and may deteriorate value development of funds. Therefore, this research focus on the costs associated with such activities and what the optimal strategy will be to limit such costs, i.e. what will provide the highest risk-adjusted return.

For the selected period investigated in the research, results are that the risk-adjusted return (Sharpe ratio) was highest for the hedged portfolio during “normal markets”. However, when including historical “black swan” events, the unhedged portfolio obtained the highest Sharpe ratio. This is due to the oil price plummeting in such events and with the NOK value having a strong negative correlation with the oil price, an unhedged portfolio will have the NOK deterioration offsetting some of the “spikes” (volatility) in fund value during such events. Hence, will then obtain a historically higher Sharpe ratio.

The research showed that currency hedging activities would amount to considerable costs over a longer time period, in addition to reduce the cumulative effect of compounding interests. For the base case portfolio in this research, a 100% currency hedging position from 2000-2020 would lead to a NOK 54m lower return on an initial NOK 100m fund value (whereby 50% invested in foreign denominated bonds), in addition to a lower Sharpe ratio. Considering the natural hedge attribute of the NOK, this research concludes that for a Norwegian high yield fund, hedging should be avoided to reduce the effect of black swan events and achieve the highest risk-adjusted return, avoid costs associated with such activities, in addition to fully benefit from the compounding interest effect over time.

As Norwegian high yield funds invest in foreign denominated assets, a risk associated with the exchange rate fluctuations occur and adds to the underlying risk of the asset. A common approach to this added risk is to utilize currency hedging activities to cope with the fluctuations and limit (or eliminate) this risk. However, such activities come with costs associated and may deteriorate value development of funds. Therefore, this research focus on the costs associated with such activities and what the optimal strategy will be to limit such costs, i.e. what will provide the highest risk-adjusted return.

For the selected period investigated in the research, results are that the risk-adjusted return (Sharpe ratio) was highest for the hedged portfolio during “normal markets”. However, when including historical “black swan” events, the unhedged portfolio obtained the highest Sharpe ratio. This is due to the oil price plummeting in such events and with the NOK value having a strong negative correlation with the oil price, an unhedged portfolio will have the NOK deterioration offsetting some of the “spikes” (volatility) in fund value during such events. Hence, will then obtain a historically higher Sharpe ratio.

The research showed that currency hedging activities would amount to considerable costs over a longer time period, in addition to reduce the cumulative effect of compounding interests. For the base case portfolio in this research, a 100% currency hedging position from 2000-2020 would lead to a NOK 54m lower return on an initial NOK 100m fund value (whereby 50% invested in foreign denominated bonds), in addition to a lower Sharpe ratio. Considering the natural hedge attribute of the NOK, this research concludes that for a Norwegian high yield fund, hedging should be avoided to reduce the effect of black swan events and achieve the highest risk-adjusted return, avoid costs associated with such activities, in addition to fully benefit from the compounding interest effect over time.